- We add five more assumptions to the list of assumptions made here:
- Factors of production cannot move from one country to another.
- No trade barriers.
- Trade is balanced; i.e., if a country plans to import something, they must pay for it using their exports.
- Labor is the only factor of production.
- Production has constant returns to scale; i.e., proportionate changes in labor input lead to proportionate change in output.
- Example: To double production, you must double labor-hour input.
Factor requirement is a key concept in classical models. It is defined as the number of labor-hour required for producing one unit of output. Here is an example: In order to produce Q units of output, we may need 1 labor-hour. Thus, to produce 1 unit of output, we may need 1/Q labor-hour. The factor requirement is, in this case, equal to 1/Q.
- Adam Smith (1776) suggests that a country has “Absolute Advantage” in producing a product for which they have lower factor requirement. Under free trade, he argues, countries may specialize in their absolute advantage, which in turn leads to greater world output. Under his approach, gain from trade is measured in terms of production.
- Given factor requirements, we may formulate relative prices in each country. A country with lower relative price for a given product (say, S) has absolute advantage in that product.
- It is possible for a given country to have no absolute advantage, which in turn implies that the other country has absolute advantage in both products. Under the assumption of balanced trade (where imports are paid for via exports) there could be no specialization. Thus, there would be no trade.
- Robert Torrens (1808) and David Ricardo (1819) suggest that a country has “Comparative Advantage” in a product for which they have their greatest absolute advantage (when they have absolute advantage in both products) or in a product for which they have their least absolute disadvantage (when they have absolute disadvantage in both products). Trade under comparative advantage may again lead to gains in production.
- Knowing the intuition behind comparative advantage, we are now able to open up the two countries in our model and let them trade under no barrier. What do we need for this?
- We need to assume some labor endowments for each country, reflecting available resources.
- We need to assume factor requirement for each product in each country, reflecting production technology.
- Given labor endowment and factor requirements, we may assume a linear production possibility frontier, the slope of which represents autarky relative prices. (Remember that we are able to formulate relative prices when we know factor requirements).
- We also need to identify autarky equilibrium in each country, which is the tangent point of production possibility frontier and community indifference curve.
- Then, we can introduce trade.
- Note: Assuming a linear production possibility frontier, the slope for the frontier is identical to the slope for the price line. The frontier, reflecting the marginal cost of production, is in a sense located exactly where the price line, which reflects the marginal revenue, is located at. The general equilibrium could be identified when community indifference curve is introduced. In autarky, optimal production/consumption may be determined by the point of tangency between production possibility frontier and community indifference curve.
The relative price under free trade is called “Terms of Trade” (henceforth, TOT). This price is greater than the lowest autarkey price, yet it is less than the highest autarky price. Otherwise, producers in low-autarky-price-country won’t engage in trade if they find that TOT is less than their marginal revenue in autarky, and consumers in high-autarky-price-country won’t engage in trade if they find that TOT is grater than the marginal cost of their purchase under autarky. In a sense, TOT is always bounded by autarky prices.
- Lower autarky price gives a country comparative advantage once trade is introduced to the model. Given the difference between TOT and autarky price, that country has an incentive to specialize in its comparative advantage — a perfect specialization occurs. Pursuing their comparative advantage, for instance, country A specializes in S, and B in T.
Click here to see the graphs in details.
- At equilibrium, the two countries in our model have congruent trade triangles as a result of market-clearing TOT. One edge of these triangles is their exports (which is equal to the difference between the production of the good in which they have comparative advantage and the domestic consumption of that good), the other edge is their imports (which is equal to the difference between the production of the good in which the other country has comparative advantage and the consumption of that good in the other country), and the last edge is the TOT line. Changes in TOT line make trade triangles congruent.
- Gains from trade as identified by classical models:
- Producers employ their resources for products in which they have comparative advantage.
- Consumers enjoy a greater level of satisfaction, reaching higher levels of community indifference curve, thanks to the new relative prices, as reflected in the TOT line.
- Note: Such level of satisfaction would not have been achievable given the existing resources and technology. It would have only been achievable if there were more resources or better technologies following economic growth. At constant levels of resources and technologies, therefore, free trade may lead countries to frontiers that economic growth would have led them to.
Click here to see the graph in details.
- The gains in classical models are the greatest for countries where autarky prices are significantly different from TOT. The closer the autarky prices to TOT, the smaller the gains from trade.
- Though classical models provide an intuitive understanding of how international trade works and how developing and even developed countries may gain from free trade, there are many shortcomings in these models. For instance:
- These models take differences in productivity as given, and they do not describe why productivity may differ between two countries.
- These models propose perfect specialization, which is empirically not relevant.
- These models fail to justify why a large share of international trade is due to trade between countries with similar levels of productivity; e.g., ongoing international trade between developed countries.